Securities Law

Under the Dodd-Frank Act of 2010, the Securities and Exchange Commission (SEC) was given expanded authority to bring enforcement actions against “any person” allegedly in violation of federal Securities and Exchange laws, with unhindered discretion as to whether these actions must be initiated before its own administrative law judges (ALJs) or in federal district courts. Since then, pursuant to its enhanced prosecutorial power, the SEC has increased its number of administrative proceedings—cases it has brought “in house”—sparking considerable controversy over the SEC’s perceived “home court advantage” and stirring up a series of constitutional challenges to its adjudicatory system. So far, only a few such challenges have garnered any success, while all others have been dismissed by federal district and appellate courts for lack of jurisdiction. Despite the attention the SEC has received, the Supreme Court has yet to address the issue, and Congress similarly has been slow to react. A federal bill addressing the matter, entitled the “Due Process Restoration Act,” has been proposed, but the bill is still in its infancy and has yet to pass the House of Representatives, much less reach the Senate.

U.S. regulation of public investment companies (such as mutual funds) is based on a notion that, from a governance perspective, investment companies are simply another type of business enterprise, not substantially different from companies that produce goods or provide (noninvestment) services. In other words, investment company regulation is founded on what this Article calls a “corporate governance paradigm,” in that it provides a significant regulatory role for boards of directors, as the traditional governance mechanism in business enterprises, and is “entity centric,” focusing on intraentity relationships to the exclusion of super-entity ones. This Article argues that corporate governance norms, which came to dominate U.S. investment company regulation as a result of the unique history of U.S. investment companies, are poorly-suited to achieve the goals of investment company regulation. In particular, the corporate governance paradigm has given rise to a number of regulatory weaknesses, which stem from investment advisers’ effective control over investment company boards of directors and courts’ deference to state corporate law doctrine in addressing investors’ grievances. Accordingly, investment company regulation should acknowledge that investment companies are not merely another type of business enterprise with the same challenges and tensions arising from the separation of ownership and control that appear in the traditional corporate context. Toward that end, this Article contends that policymakers should view, and regulate, investment companies as an avenue through which investment advisers provide financial services (investment-advisory services, in particular) to investors–and should view investment company shareholders more as advisory customers than as equity owners of a firm. This “financial services” model of regulation moves past the entity focus of corporate governance norms and, therefore, permits dispensing with governance by an “independent” body such as the board of directors. More importantly, if adopted, this model would remedy some of the more significant problems plaguing U.S. investment company regulation.

This Article fills a gap in commercial finance law. Despite the fact that “securitization” has become enormously important to capital markets–and is sometimes blamed for the financial crisis–we have no agreed understanding of the term. Various regulators and commentators have generated a wide range of definitions, but many are vague or omit crucial elements. Perhaps more surprising, the Dodd-Frank financial services reform–the most aggressive attempt yet to regulate securitization–does not define it at all. How can we regulate something without a shared conception of what it is?

In order to develop a more fully considered definition of the term, this Article assesses data on the performance of securitizations, as well as the transaction form’s essential elements (its inputs, structure, and outputs). The definition offered here distinguishes “true” securitizations from other transactions, such as collateralized debt obligations and Enron’s structured financings. While the latter transactions may satisfy many current definitions of (or associated with) securitization, they in fact lack one or more essential elements of true securitizations. Not surprisingly, such transactions largely failed to advance the legitimate social and economic goals of securitization, the most basic of which is to connect the buyers and sellers of capital more effectively than traditional financing methods, such as bank lending or issuing shares of stock.

In Re: Defining Securitization, Professor Jonathan Lipson attempts to define a “true” securitization transaction, ultimately characterizing it as “a purchase of primary payment rights by a special purpose entity that (1) legally isolates such payment rights from a bankruptcy (or similar insolvency) estate of the originator, and (2) results, directly or indirectly, in the issuance of securities whose value is determined by the payment rights so purchased.” There is much to admire in Lipson’s attempt but also much to question.

In his brief essay, What Is Securitization? And for What Purpose? (“Purpose”), Professor Steven Schwarcz does me a great honor in responding to my article, Re: Defining Securitization (“Re: Defining”), where I ask what, exactly, does the term “securitization” mean?

As serious observers of, and participants in, securitization know, Professor Schwarcz is one of the leading authorities on the subject. His works–for both professional and academic audiences–are must-reads. Thus, if, as I say in Re: Defining, my goal was to be not the last word on this question but the first, the fact that he has written such a thoughtful response tells me I have succeeded.

Nevertheless, several of his criticisms warrant scrutiny. Unaddressed, they may leave readers misunderstanding the purpose of the definitional exercise I undertake in Re: Defining. Thus, I offer this brief “sur-reply” to Professor Schwarcz, which has four primary parts.

“Banks don’t lend anymore. Hedge funds have stepped in.” Lee Sheppard wrote these words in 2005, but the financial crisis starting in 2008 has shone a spotlight on this significant change in the reality of modern finance. What role hedge funds may have played in causing the financial crisis is debatable, but few will dispute that U.S. businesses have had trouble finding capital even as the economy, on the whole, has started to recover.

There are many possible contributors to the onset of the capital crunch. Among them are banks, which had difficulties meeting capital requirements, in part because their balance sheets were weighed down by mortgage-backed securities that proved to be less valuable than initially thought, and in part because of changes in accounting rules, as well as increases in minimum capital reserve requirements. The U.S. government and the Federal Reserve responded by combining to invest trillions of dollars to purchase “toxic” securities, guarantee loans, provide additional loans, and make direct capital injections into troubled financial institutions.

While the causes of the recent financial crisis have been debated extensively, the conclusion that excessive leverage by financial institutions contributed to the crisis has garnered widespread support. Concerns over the role of leverage have spurred a renewed focus on banks’ ability to exploit the presence of moral hazard due to limited liability and the government’s tendency to rescue banks in distress. The crisis painfully underscored how banks use leverage to increase their expected returns while simultaneously shifting risk to creditors and the public at large.

Modification-proof contracts boost commitment and can help overcome information problems. But when such rigid contracts are ubiquitous, they can function as social suicide pacts, compelling enforcement despite significant externalities. At the heart of the current financial crisis is a contract designed to be hyperrigid: the pooling and servicing agreement (“PSA”), which governs residential mortgage securitization. The PSA combines formal, structural, and functional barriers to its own modification with restrictions on the modification of underlying mortgage loans. Such layered rigidities fuel foreclosures, with spillover effects for homeowners, communities, financial institutions, financial markets, and the macroeconomy.

This Article situates PSAs in the context of theoretical and policy debates about contract rigidity, bond contract modification, and contractual bankruptcy. We propose a typology of contract rigidities, ranging from formal prohibition on amendment (formal rigidity) to extreme collective action problems (functional rigidity). We then draw on New Deal jurisprudence for strategies to overcome each type of rigidity. These strategies include narrowly tailored legislation that renders the problematic terms unenforceable on public policy grounds, administrative restructuring mandates, and special bankruptcy regimes.

Recent Supreme Court decisions, including Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. and Tellabs, Inc. v. Makor Issues & Rights, Ltd., have brought complex securities fraud issues back into the national limelight. Moreover, growing frustration with the Sarbanes-Oxley Act of 2002 and the current financial catastrophe have further intensified securities concerns. Regardless of which side one supports in the ongoing debate regarding appropriate regulation, one thing is certain: securities fraud continues to purge the American markets of billions of dollars per year. With today’s political disposition favoring increased government oversight of corporate America, and with a new presidential regime, the time for reevaluating America’s procedure for detecting and deterring large-scale securities fraud is swiftly approaching.

Consider the following hypothetical: the Securities and Exchange Commission (“SEC”) is investigating a corporation for stock option backdating by the corporation’s officers and directors, and possible criminal charges are looming. The implicated company fires an executive, and seals her office. All of the executive’s documents inside the office, including her personal documents, are subpoenaed by the SEC. In a modern world, both work related documents and purely personal documents are often left at the office. These documents could include, but are not limited to, personal bank statements, other personal financial documents, letters, a diary, and even medical information. While personal files could have nothing to do with the corporation, the corporation must turn over these documents to the SEC pursuant to a valid subpoena. The SEC later can provide these documents to the U.S. Attorney’s office in a parallel criminal investigation of securities fraud. In a traditional criminal case, the government would need a search warrant and probable cause to enter someone’s home or office and take personal documents from the individual. Through the SEC subpoena, however, the documents may be subpoenaed for mere “official curiosity” and then handed over to the U.S. Attorney’s office, as long as the parallel proceedings were not carried out in bad faith.